Chapter 1: Accounting Information and Decision making
The chapter is divided into 3 parts and 1 Appendix. Part A gives a brief overview of the overall accounting. Part B gives financial accounting information. Part C specifies various career options in accounting. Besides the three parts, the appendix to the chapter provides the conceptual framework essential for the development of accounting standards and interpretation of accounting information. Lets start with Part A.
Accounting is “the language of business.” It is a system of maintaining records of a company’s operations and communicating this information to decision makers. The decision makers are people who make decisions about the company based on accounting information. The functions of accounting are to measure the activities of the company and to communicate those measurements to people. The primary users or decision makers are investors and creditors. Besides this, a variety of other users make use of accounting information ranging from customers to suppliers, from managers to employees, to competitors, regulators and tax authorities.
Accounting can be classified into two broad categories: managerial accounting and financial accounting. Managerial accounting deals with the methods accountants use to provide information to an organization’s internal users; that is, its own managers. It is not the subject of the course. The course focuses on financial accounting. The two primary functions of financial accounting are to measure business activities of a company and to communicate those measurements to external parties for decision-making purposes.
The first of financial accounting’s roles is to measure business activities, commonly referred to as transactions . A business engages in three fundamental activities – financing activities, investing activities, and operating activities. Financing activities are transactions involving external sources of funding. There are two basic sources of this external funding – the owners of the company who invest their own funds in the business, and creditors who lend money to the company. With these funds collected, the company engages in investing activities that include the purchase and sale of (1) long-term resources such as land, buildings, equipment, and machinery and (2) any resources not directly related to a company’s normal operations. These are the resources needed to run the business. Once these investments are in place, the company can perform operating activities that include transactions that relate to the primary operations of the company, such as providing products and services to customers and the associated costs of doing so, like utilities, taxes, advertising, wages, rent, and maintenance.
The questions that arise here are “How should accountants measure the business activities?” Or in other words, “What information would a company’s investors and creditors be interested in knowing to make informed decisions?”. Ultimately, investors and creditors want to know about the company’s resources and their claims to those resources. We measure resources owned by a company as Assets which can be land, building, equipment, cash, inventory etc. Two parties claim the resources of the company – creditors and investors. Liabilities are amounts owed to creditors. Few examples can be amounts owed to bank, suppliers, government etc. They must be paid by a specified date. Stockholders’ equity Investors, or owners, claim any resources of the company not owed to creditors. For a corporation (means an entity that is legally separate from its owners), we refer to owners’ claims to resources as stockholders’ equity , since stockholders are the owners of the corporation. The relationship among these three measurement categories is shown in the basic accounting equation that is Assets = Liabilities + Stockholders’ Equity
Stockholders claim all profits because they are the owners of the company so the profits are rightfully theirs. We calculate a company’s profitability by comparing its revenues and expenses. Revenues are the amounts earned from selling products or services to customers. Expenses are the costs of manufacturing products or providing services. The difference between revenues and expenses is net income (or profit or earnings); corporations will distribute some of these profits to its owners/stockholders as dividends . If expenses exceed revenues, then the company reports a net loss.
The three major types of business organizations are: sole proprietorship, partnership, and corporation. A sole proprietorship is a business owned by one person, whereas a partnership is a business owned by two or more persons. If you have decided to start a business without outside investors, you can form a sole proprietorship. If you want to start it with your friend, you can form a partnership. A corporation is entirely different from these two forms. It is an entity that is legally separate from its owners and involves outside investors in the business through issuance of shares. Thus, external funding is raised when individuals purchase shares of ownership (typically referred to as common stock) in the corporation. Each share of stock represents a unit of ownership.
Financial statements are periodic reports published by the company for the purpose of providing information to external users. We have four primary financial statements: Income Statement. Statement of Stockholders’ Equity. Balance Sheet. Statement of Cash Flows. Let’s have a look at each one of them.
The income statement is a financial statement that reports the company’s revenues and expenses over an interval of time. It shows whether the company was able to generate enough revenue to cover the expenses of running the business. As we have considered earlier, if revenues exceed expenses, then the company reports net income . But, if expenses exceed revenues, then the company reports a net loss .
Let’s consider the case of “Eagle Golf Academy” which started its operations on January 1. For the first month of operations, Eagle Golf Academy reports its income statement as shown in the Illustration. Notice the heading of the income statement includes the company’s name , the title of the financial statement, and the time period covered by the financial statement. The three major captions in the income statement include revenues and expenses , discussed earlier, and the difference between them – net income .
The statement of stockholders’ equity is a financial statement that summarizes the changes in stockholders’ equity over an interval of time. Stockholders’ equity has two primary components – common stock and retained earnings . Common stock represents amounts invested by stockholders (the owners of the corporation) when they purchase shares of stock. Common stock is an external source of stockholders’ equity. Retained earnings , on the other hand, is an internal source of stockholders’ equity. Retained earnings represent the cumulative amount of net income earned over the life of the company that has not been distributed to stockholders as dividends. Since all profits of the company are owned by stockholders, any net income in excess of dividends paid to stockholders represents stockholders’ equity retained in the business. Thus, both common stock and retained earnings make up total stockholders’ equity.
Suppose Eagle obtains financing in January by issuing common stock for $25,000. This transaction will distribute shares of common stock to investors in return for the company’s receiving cash of $25,000. At the end of January Eagle pays dividends of $200 to stockholders. When the company begins operations on January 1, the balances of common stock and retained earnings are $0. Once the company issues common stock, its balance increases to $25,000. The balance of retained earnings always increases by the amount of net income less any dividends paid to stockholders, in this case, $500 - $200 = $300. By adding common stock and the retained earnings of $300, we calculate the balance of total stockholders’ equity at January 31 to be $25,300. This amount represents the value of the firm to its owners i.e. the stockholders, in accounting terms.
The balance sheet is a financial statement that presents the financial position of the company on a particular date. The financial position of a company is summarized by the basic accounting equation: assets = liabilities + stockholders’ equity. Assets are the resources owned by the company, whereas liabilities are amounts owed to creditors. This means that stockholders have equity (or net worth) to the extent that assets exceed liabilities.
The first thing to notice is the time period included in the heading. Recall that the income statement and statement of stockholders’ equity, both show activity over an interval of time , the balance sheet, in contrast, reports assets, liabilities, and stockholders’ equity at a point in time . Total assets equal $39,500 and include some of the typical resources owned by most businesses, such as cash, supplies, and equipment. Total liabilities equal $14,200 and include amounts owed to regular vendors (accounts payable), as well as amounts owed for other items such as employee salaries, interest, and utilities. The difference of $25,300 represents stockholders’ equity and it includes retained earnings from the statement of stockholders’ equity. Notice that the amounts listed in the balance sheet show that the accounting equation balances.
The statement of cash flows is a financial statement that measures activities involving cash receipts and cash payments over an interval of time. We can classify all cash transactions into three categories that correspond to the three fundamental business activities we discussed earlier: (1) operating activities, (2) investing activities, and (3) financing activities. Operating cash flows include cash receipts and cash payments for transactions involving revenues and expenses. Investing cash flows generally include cash transactions for the purchase and sale of investments and productive long-term assets. Financing cash flows include cash transactions with lenders, such as borrowing money and repaying debt, and with stockholders, such as issuing stock and paying dividends.
Net cash flows from operating, investing, and financing activities equal the net change in cash during the period. To this change, we add the beginning balance of cash. Since this is the first month of operations for Eagle, cash at the beginning of the month is zero. The ending balance of cash is the same as that reported in the balance sheet. This reconciliation of the beginning and ending cash balances emphasizes that the statement of cash flows explains why the cash reported in the balance sheet changed. The statement of cash flows can be an important source of information to investors and creditors. For example, investors use the relationship between net income and operating cash flows to forecast a company’s future profitability. Creditors compare operating cash flows and investing cash flows to assess a company’s ability to repay debt. Financing activities provide information to investors and creditors about the mix of external financing of the company.
The figure portrays the link among financial statements of Eagle Golf Academy. The net income balance from the income statement will be used to calculate the stockholders’ equity. The balance of stockholders’ equity is then transferred to the balance sheet. Notice that cash balance in the balance sheet should match with ending cash balance in the statement of cash flows. Any transaction that affects the income statement ultimately affects the balance sheet through the balance of retained earnings.
Part B: Financial Accounting Information
Financial accounting information is essential to making good business decisions. The figure demonstrates that investors and creditors have cash they are willing to invest. How do they decide which investment option provides the better opportunity? Most often, they analyze companies’ financial accounting information in making their decision.
To demonstrate the importance of financial accounting information to investment decisions, let’s look at the relationship between changes in stock prices and changes in net income over 20 years. You can see that if you had invested $1,000 in companies with an increase in net income, your investment would have increased to $18,225 over the 20-year period. (The amount would have been much higher without the extraordinary events surrounding the financial crisis in 2008.) If instead you had invested $1,000 in companies with a decrease in net income, your $1,000 investment would have shrunk to $49 over this same period. This dramatic difference in the value of the investment demonstrates the importance of financial accounting information to investors.
Formal standards for reporting financial accounting information have been established, and all companies that publish financial statements must follow these rules because it allows investors and creditors to accurately compare financial information among companies when they are making decisions about where to lend or invest their resources. The rules of financial accounting are called Generally Accepted Accounting Principles , often abbreviated as GAAP . The fact that all companies use these same rules is critical to financial statement users. It allows them to accurately compare financial information among companies when they are making decisions about where to lend or invest their resources.
Today, financial accounting and reporting standards in the United States are established primarily by the Financial Accounting Standards Board (FASB). The FASB is an independent, private sector body with seven full-time voting members and a very large support staff. The global counterpart to the FASB is the International Accounting Standards Board. The standard-setting body responsible for this convergence effort is the International Accounting Standards Board (IASB). Securities and Exchange Commission (SEC), a government agency created in 1934, has got both the power and the responsibility for setting accounting and reporting standards for companies whose securities are publicly traded. The SEC has delegated the primary responsibility for setting accounting standards to FASB.
Auditors are not full-time employees of the company they are auditing. Instead, auditors are trained individuals hired by a company as an independent party to express a professional opinion of the accuracy of that company’s financial statements. If they find mistakes or fraudulent reporting behavior, auditors require the company to correct all significant information before issuing financial statements. Thus, the role of auditors is to help ensure that management has in fact appropriately applied GAAP in preparing the company’s financial statements. Also, they play a major role in investors’ and creditors’ decisions by adding credibility to the financial statements.
The objective of Financial accounting is to provide information that: 1. is useful to investors and creditors in making decisions. 2. helps to predict cash flows. 3. tells about economic resources, claims to resources, and changes in resources and claims.
Investors, creditors, government, and the general public rely on general ethical behavior among those who record and report the financial activities of businesses. Indeed, the dramatic collapse of Enron in 2001 and the dismantling of the international public accounting firm of Arthur Andersen in 2002 severely shook investors’ confidence in the stock market. Some questioned the credibility of corporate America as well as the accounting profession itself.
Public outrage over accounting scandals at high-profile companies increased the pressure on lawmakers to pass measures that would restore credibility and investor confidence in the financial reporting process. Formally titled the Public Company Accounting Reform and Investor Protection Act of 2002, commonly referred to as the Sarbanes-Oxley Act (SOX) , named for the two congressmen who sponsored the bill.
Part C: Careers in Accounting
The first big decision a student makes as an accounting graduate is the choice between a career in public accounting and a career in private accounting. Public accounting firms are professional service firms that traditionally have focused on three areas: auditing, tax preparation/planning, and business consulting. “Big 4” public accounting firms are Deloitte, Ernst & Young, PricewaterhouseCoopers, and KPMG. You can work either with Big 4 or Non-Big 4. A career in private accounting means providing accounting services to the company that employs you.
Other career options can be in the domain of governmental accounting, sole proprietorship and education.
Appendix: Conceptual Framework
The FASB establishes financial accounting standards based on a conceptual framework , which you can think of as the “theory” of accounting. The FASB’s conceptual framework prescribes the “correctness” of financial accounting rules. The conceptual framework provides an underlying foundation for the development of accounting standards and interpretation of accounting information. The figure provides a graphical depiction of the qualitative characteristics of accounting information. Notice that the main focus is on decision usefulness—the ability of the information to be useful in decision making. The two primary decision-specific qualities that make accounting information useful are relevance and faithful representation . Both are critical. No matter how representative, if information is not relevant to the decision at hand, it is useless. Conversely, relevant information is of little value if it does not accurately represent the underlying activity. Four enhancing qualitative characteristics are comparability, verifiability, timeliness, and understandability.
The four basic assumptions underlying GAAP are (1) the economic entity assumption, (2) the monetary unit assumption, (3) the periodicity assumption, and (4) the going concern assumption. The economic entity assumption states that we can identify all economic events with a particular economic entity. Another key aspect of this assumption is the distinction between the economic activities of owners and those of the company. For example, Michael Dell’s personal residence is not an asset of Dell Incorporated. According to the monetary unit assumption , to measure financial statement elements, we need a unit or scale of measurement. The dollar in the United States is the most appropriate common denominator to express information about financial statement elements and changes in those elements. The periodicity assumption relates to the qualitative characteristic of timeliness. External users need periodic information to make decisions. This need for periodic information requires that the economic life of an enterprise (presumed to be indefinite) be divided into artificial time periods such as a quarter, an year for financial reporting. The going concern assumption states that, in the absence of information to the contrary, a business entity will continue to operate indefinitely. It provides justification for measuring many assets based on their original costs.
Part A Accounting as a Measurement/Communication Process 1-
LO1 Basic Understanding of Accounting Accounting – The language of business 1- Make Decisions About Communicate information t o: Activities Measured b y: People Companies Accountants
Accounting Categories Managerial Accounting deals with the methods accountants use to provide information to an organization’s internal users; that is, its own managers . Financial Accounting measures business activities of a company and communicates those measurements to external parties for decision-making purposes. Focus of the Course 1-
LO2 Business Activities to Measure Financing activities Investing activities Operating activities Business Activities Involves funding from external sources Involves purchase and sale of long-term resources Involves transactions in primary operations of business 1-
Basic Accounting Equation 1- Assets Liabilities Stockholders’ Equity = + Investors and Creditors would like to know about Company’s resources Claims to those resources
Profitability Revenue > Expenses Revenue < Expenses Dividends Company distributes 1- Net Income Net Loss
Forms of Business Organizations Sole Proprietorship Partnership Corporation 1- Owned by a single person Legally separate from its owners Owned by two or more persons
LO3 Communicating Through Financial Statements Financial statements are periodic reports published by the company for the purpose of providing information to external users. 1- Statement of Stockholders’ Equity Income Statement Statement of Cash Flows Balance Sheet
Income Statement Financial statement that reports the company’s revenues and expenses over an interval of time Shows whether the company was able to generate enough revenue to cover the expenses of running the business If Revenues > Expenses then Net Income If Revenues < Expenses then Net Loss 1-
Statement of Stockholders’ Equity Financial statement that summarizes the changes in stockholders’ equity over an interval of time. 1-
Statement of Stockholders’ Equity for Eagle Golf Academy 1-
Balance Sheet Financial statement that presents the financial position of the company on a particular date Summarized by the basic accounting equation: Assets = Liabilities + Stockholders’ Equity 1-
Statement of Cash Flows Financial statement that measures activities involving cash receipts and cash payments over an interval of time. Can be classified into three categories Operating cash flows Investing cash flows Financing cash flows 1-
Statement of Cash Flows for Eagle Golf Academy 1-
Link among Financial Statements EAGLE GOLF ACADEMY Income Statement Revenues $6,360 Expenses 5,860 Net income $ 500 EAGLE GOLF ACADEMY Statement of Stockholders’ Equity Common Stock Retained Earnings Total Stockholders’ Equity Beginning balance (Jan. 1) -0- -0- -0- Issuances $25,000 $25,000 Add: Net income 500 500 Less: Dividends (200) (200) Ending balance (Jan. 31) $25,000 $300 $25,300 EAGLE GOLF ACADEMY Balance Sheet Cash $ 6,200 Liabilities $ 14,200 Other assets 33,300 Stockholders’ equity 25,300 Total liabilities and stockholders’ equity $39,500 Total assets $39,500 1- EAGLE GOLF ACADEMY Statement of Cash Flows Cash Flows from Operating Activities ($4,600) Cash Flows from Investing Activities (24,000) Cash Flows from Financing Activities 34,800 Net increase in cash 6,200 Cash at the beginning of the year 0 Cash at the end of the year $6,200
LO4 Importance of Financial Accounting Option A Option B Financial Accounting Information Investors and creditors Investment Choices ? Financial accounting information is essential to making good business decisions 1-
* Amounts in this chart represent the investment growth based on the median stock return of each group each year. Companies included in this analysis are all U.S. companies with listed stocks, which averages about 6,000 companies per year. 1-
LO5 Rules of Financial Accounting Investors & Creditors Financial Accounting Information Generally Accepted Accounting Principles (GAAP) make their decisions based on Should be based on formal standards 1-
Current Standard Setting United States Globally Financial Accounting Standards Board (FASB) International Accounting Standards Board (IASB) Governed by Securities and Exchange Commission (SEC) 1-
Role of Auditors Auditors are trained individuals hired by a company as an independent party to express a professional opinion of the accuracy of that company’s financial statements. Role of auditors Help ensure that management has in fact appropriately applied GAAP in preparing the company’s financial statements Help investors and creditors in their decisions by adding credibility to the financial statements. 1-
This act provides regulation of auditors and the types of services they furnish to clients, increases accountability of corporate executives, addresses conflicts of interest for securities analysts, and provides for stiff criminal penalties for violators.
Assumptions for GAAP Identify all economic events with a particular economic entity Need a unit or scale of measurement Provide information of an enterprise at regular time periods Business entity will continue to operate indefinitely Economic Entity Assumption Monetary Unit Assumption Periodicity Assumption Going Concern Assumption 1-